Post on 18-Dec-2015
transcript
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Macro-Prudential Policy:Rationale and Key Issues
Rio de Janeiro23 March 2012
Chief Economist OfficeLatin America and the CaribbeanThe World Bank
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Structure of the presentation
Systemic oversight and macro-prudential policy
Macro-prudential policy (MPP): distinct objective, independent instrument?
The fundamental rationale for MPP
Lines of MPP defense
Issues in MPP design
Final thoughts
[Extra slides – the empirical case for MPP in LAC]
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Systemic oversight and macro-prudential policy
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Systemic oversight – key distinctions
Systemic oversight “Macro-prudential” – the dynamic dimension of systemic regulation “Micro-systemic” – the cross-section dimension of systemic regulation “Systemic supervision” – the monitoring (and enforcement) dimension
“Micro-systemic” issues Regulatory perimeter
• Outer boundary – illuminating the shadows • Inner boundary – silos vs. universal banking license; conglomeration
The SIFI problem Systemic supervision issues
New connections: parts to whole, through time, stability & development Approach: top-down vs. bottom up; on-site & off-site; use of market discipline New tools; institutional arrangements; skills
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Macro-prudential policy
Distinct objective? Independent instrument?
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Distinct objective calls for independent instrument
Non-reducible, ultimate objective of macro-prudential policy (MPP) is to achieve sustainable financial system dynamics Focus of MPP—enhance financial system resiliency to fluctuations
(buffering) & mitigate financial-real amplification effects (dampening)
Objective of MPP is not perfectly correlated with that of monetary policy (MP) MP objective is to coordinate and anchor agents expectations around a
low and stable inflation target The “divine coincidence” is a special (not a general) case
• E.g., in the face of a negative aggregate demand shock, lowering the MP interest rate can also achieve MPP ad competitiveness objectives
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Distinct objective independent instrument (2)
MP can be a suboptimal tool achieve MPP objectives; conversely, MPP can overreach Given an MPP objective, the i-rate can be inferior to an MPP instrument An MPP instrument may be used to pursue non-MPP objectives (e.g., to
deal with “fear of appreciation”), for which it is not the best tool
There is a fuzzy area where MPP and other macro objectives overlap; hence, identifying the best policy tool might not be easy E.g., frothy capital inflows leading to excessive appreciation raise
concerns about competitiveness as well as about financial system risks
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The fundamental rationale for MPP
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Market failure stories that justify MPP (1)
Agency and collective action frictions/failures that amplify exogenous shocks in models with rational agents Typically modeled with rational expectations Shock tightens constraint (say, collateral or information) fire sales
asset/collateral prices fall more fire sales … and so on The un-internalized externalities of fire sales lead to socially excessive
leverage & credit expansion (Jeanne & Korinek, 2011) The amplified change in asset prices of fire sales ends up validated by
changes in fundamentals, as price setting shifts• From the more to the less informed (Shleifer & Vishny, 1997) • From agents with better technologies to agents with worse ones (Kiyotaki
and Moore, 1997)• From optimists to pessimists (Geanakoplos, 2009)
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Market failure stories that justify MPP (2)
Endogenous adverse dynamics driven and amplified by cognition frictions/failures reflecting bounded rationality Difficult to model mathematically (de Grauwe, 2009; Lo, 2009)
• In the tradition of Keynes, Minsky, Kilderberger, and Shiller …• … supported by growing behavioral finance evidence (Kahneman & Tversky,
2002; Montague, 2007) Focus is on non-reducible uncertainty, heuristically adjusted expectations,
and the associated mood swings• “The market will be subject to waves of optimistic and pessimistic sentiment,
which are unreasoning, yet in a sense legitimate … [because of uncertainty] … no solid basis exists for a reasonable calculation” (Keynes, 1936)
Up the cycle – exuberant euphoria, typically fueled by financial innovation Down the cycle – panic and acute uncertainty aversion, fueled by socially
costly flight to liquidity
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Market failure stories that justify MPP (3)
The two market failure stories clearly justify MPP …
… and lead to similar policy implications, in many respects
But, in some important respects, they have very different policy implications Buffers vs. dampeners: combating mood swings primarily implies
dampening (rather than buffering) Rules vs. discretion: mood swings are less predictable and less
responsive to incentives, hence calling for more discretion Price-based vs. quantity-based regulation: mood swings will be less
responsive to price incentives such as capital charges
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Lines of MPP defense
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Lines of macro-prudential policy defense
Avoid contributing to amplification – don’t rock the boat Remove pro-cyclicality in macro and traditional regulatory policy Allow prudential buffers to be true buffers—i.e., to be used without
penalty during downswings (Goodhart, 2010; Hellwig, 2010) Remove deeper pro-cyclical factors, such as currency mismatches and
social moral hazard (expectation of bailouts or “Greenspan put”) Enhance financial system resiliency to cycle – build a better boat
Add more, cycle-dependent buffers (liquidity and solvency) Dampen the cycle – tame the (excess) amplitude of the waves
Emphasis on MMP instruments as dampeners Nip the gestation of adverse amplifications in the bud
Induce the internalization of externalities (Pigovian taxes) Prevent buildup of exuberance (approval protocols for innovations)
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Issues in MPP design
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Sweet spot vs. overkill
Financial cycles in part reflect fundamental factors that are themselves pro-cyclical Investment opportunities and credit demand rise in the upswing and
riskiness of borrowers truly decline Schumpeterian creative destruction is intertwined with finance Rapid financial expansion may just be sustainable catch-up growth—i.e.,
difficult to distinguish financial development trends vs. cycles It thus makes no sense to aim at flattening the cycle altogether
The fact that only a small fraction (one in ten) of credit booms end up crashes is a warning against over-activism
The focus should be on containing the “excessive,” socially undesirable financial amplification effects and their implications
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Buffers vs. dampeners
The focal point: stronger boats or smaller waves? Buffers make the financial system more resilient to macro-financial
turbulence (main concern of supervisors) Dampeners limit the amplitude of macro-financial turbulence (main
concern of central bankers) The policy response
As one goes from agency frictions to externalities and to mood swings the MPP objective increasingly shifts from buffering to dampening
Buffers need to be usable in downswings modify traditional focus on fixed, cycle-independent minimum requirements
Big research agenda to ascertain effectiveness of alternative tools • Balance sheet (capital, provisions, leverage, liquidity): primarily buffering?• Lending (LTV, DTI, RR): primarily dampening?
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Rules vs. discretion
The focal point: automatic lower speeds or a vigilant captain Rules limit regulatory uncertainty (hence the cost of regulation) and
regulatory capture (hence the effectiveness of regulation) But in view of uncertainties, a pure rules-based MPP can be insufficient or
may introduce excessive deadweight costs The policy response
Untested nature of instruments and mood swings stories argue for tilting the balance in favor of discretion, which is congenial to MPP dampeners
Rules are more congenial to buffers and to a world of rational agents But discretion calls for a much bigger institutional reform agenda
• Judgment-based MPP would require governance (transparency, accountability) arrangements akin to those for MP—a tall order indeed
• Even more difficult for MPP compared to MP because policy costs of MPP are localized, hence are more likely to generate opposition and ill will
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Price vs. quantities
State-dependent choices Depend on uncertainty and the slope of the social marginal benefit
curve relative to the private marginal cost curve (Weitzman 1974)• Steeper social marginal benefit => quantities (plays it safe)• Flatter social marginal benefit => prices (maximizes efficiency)
Depend on financial intermediaries’ response to incentives• Tightly-controlled system => prices (nip it in the bud)• Unsound or exuberant systems => quantities (too late for prices)
The policy response In a world of pure agency frictions and rational agents a price-based
MPP policy is likely to dominate In a world marked by externalities and mood swings, quantities are likely
to dominate, reflecting uncertainty and non-linearities at the tails
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Specific vs. broad
Aggregate vs. institution-specific Across the board (top-down) application based on aggregate triggers may
have greater dampening effect … … but (bottom-up) application that is differentiated by institution is less
distortive – it does not punish the more prudent lenders All types of lending vs. targeted types of lending
E.g., housing lending-focused (such as adjustable LTV and DTI ceilings) Sector-specific interventions are better targeted to the epicenter of
amplification but may be harder to calibrate, more vulnerable to circumvention, and more likely to distort credit allocation
Things are further complicated by the lack of well-defined, easy-to-agree indicators and levers for MPP Implementation difficulties raise risk of doing more harm than good
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Final thoughts
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MPP – reminders as we move forward
Warnings A strong case for MPP that is, to a significant extent, judgment-based … but much uncertainty on effectiveness of MPP (big research agenda) Benefits and costs of MPP materialize at different points in time Deployment of MPP is not free of cost
Criteria Gradual approach: use the four lines of defense in organizing strategy Put in place a proper institutional framework for judgment-based MPP Use MPP as a complement (not substitute) to fiscal & monetary policy
E-rate flexibility enhances MP and MPP independence Tensions can arise: MPP can reduce the need for MP tightening and thus
limit e-rate volatility, which can in turn reduce MPP independence
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Thank you
Extra Slides
The case for macro-prudential policy in LAC
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Financial cycles in LAC’s history – stylized facts
Financial cycles in LAC have been quite frequent and more pronounced Capital flow cycles more frequent, house price booms less, credit similar Credit cycles of longer duration and greater amplitude than elsewhere
• The median drop in credit per capita in peak-to-trough phases has been 18%, four time higher than in advanced countries
Credit cycles (at turning points) have tended to precede output cycles and follow asset (equity and even housing price) cycles Unexpectedly, on average, capital flow bonanzas have been less likely to
be followed by credit booms in LAC LAC’s financial cycles have more often ended in crises
Frequency of banking crisis following credit booms has been higher Credit booms as the best predictor of crisis, even after controls
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The anatomy of LAC’s past financial cycles (1)
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Unconditional probability of booms and crises
0%
2%
4%
6%
8%
10%
12%
14%
16%
Banking Crisis Lending Booms Equity price booms Housing price booms Capital flow bonanzas
Industrial Countries Non-LAC EMs Latin America (LAC)
The anatomy of LAC’s past financial cycles (2)
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11.7.1 Average Duration of the Cycle of Real Credit per Capita
-10
-8
-6
-4
-2
0
2
4
6
8
1980-9 1990-9 2000-9 1980-9 1990-9 2000-9 1980-9 1990-9 2000-9
Industrial countries Latin America Non-LAC EMs
Upturn Downturn
11.7.2 Median Amplitude
-0.3
-0.25
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
1980-9 1990-9 2000-9 1980-9 1990-9 2000-9 1980-9 1990-9 2000-9
Industrial countries Latin America Non-LAC EMs
Upturn Downturn
The anatomy of LAC’s past financial cycles (3)
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[1] [2] [3] [4]
Credit
Real credit 1.1555 ** 1.3246 2.5876 * 2.6228 *
(amplitude of preceding upturn) (0.518) (1.027) (1.364) (1.405)
Capital flows
Ratio of non-FDI inflows to GDP .. -0.1269 -1.2177 -1.3084
(amplitude of preceding upturn) (1.844) (2.306) (2.308)
Asset prices
Real Exchange Rate .. .. 2.1246 2.2336
(amplitude of preceding upturn) (2.208) (2.291)
Stock prices (real) .. .. 0.1658 0.0984
(amplitude of preceding upturn) (0.523) (0.560)
Leverage of the banking system
Credit-Deposit ratio .. .. .. -0.3075
(T-P amplitude) (0.528)
Constant -1.4536 ** -1.3826 ** -1.8141 ** -1.7686 **(0.163) (0.256) (0.345) (0.366)
Nobs. 298 144 116 110
Log likelihood -108.4 -58.0 -38.3 -36.8
Pseudo R**2 0.0623 0.0581 0.2084 0.193
Size of Financial Booms and the Probability of Crisis: Probit AnalysisSample: 79 countries, 1970q1-2010q4
Numbers in parenthesis represent robust standard errors. * (**) indicates that the coefficient is statistically significant at the 10 (5) percent level.
Financial cycles in LAC– past, present and future
What does the past say about the future for LAC? In pre-crisis decades, the duration, amplitude and intensity of credit
cycles declined across the world … …. in LAC, accentuated by improved macro-financial “immune system” Hence, a simple extrapolation of past macro-financial turbulence not the
best guide to design future MPP for LAC … … but the relative importance of credit cycles and the sequencing results
will likely survive, given that financial structure changes slowly What is the present adding?
“Double tailspin push” (commodity prices & capital inflows) stemming from world-wide cycle asynchronicity is interacting with still stimulative macro in LAC credit boom formation (potential systemic risk buildup)
LAC macro constraints (fiscal rigidity, historically high i-rates, open capital account) and rising interconnectedness raise premium of MPP
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